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Using Purchasersí Deposits: A Windfall for Developers?

By James Speakman                            January 13, 2005 

Access to capital, whether in the form of the developerís own equity, conventional financing, mezzanine financing, or syndicated equity or debt, is a key to being able to participate in todayís flourishing real estate market. Development and investment opportunities seem to abound. Having enough financial capital to take advantage of these opportunities is an issue for many participants in the market (having enough human capital is also becoming an issue, but that topic will not be dealt with in this article).

In a previous article, we discussed opportunities for raising real estate capital through syndicated equity and debt structures. A new opportunity, perhaps, for developers of residential projects in British Columbia is to use the purchasersí deposits as part of the equity required for development and construction costs. This article discusses the new legislative regime which allows developers to use these deposits and my expectation of how the process for accessing deposits may actually work.

Real Estate Development Marketing Act

The Real Estate Development Marketing Act (the New Act) was brought into force on January 1, 2005. As a replacement for Part 2 of the Real Estate Act (the Old Act), the New Act is intended to streamline project marketing activities, provide greater opportunity for the pre-sales of developments, and reduce the regulatory burden on developers with respect to disclosure to purchasers. A key feature of the New Act permits developers to have access to the purchasersí deposits for the payment of project costs, subject to the provision of an insurance contract and the satisfaction of other conditions.

Under the Old Act, any deposits paid by a purchaser of a new residential property were required to be held in trust by a lawyer, notary public or real estate agent until legal title to the property had been issued by the Land Title Office and transferred to the purchaser. As well, the Old Act required that deposits could not exceed 10% of the purchase price of the property until the developer had a building permit and the financing required to complete the project.

The New Act maintains the 10% limit on the deposit. However, section 19 of the New Act provides that a developer may use the purchasersí deposit monies (both before and after obtaining a building permit and financing) to fund the construction of the project, subject to the following:

  • The developer must enter into a "deposit protection contract", as defined in the Insurance Act. A "deposit protection contract" indemnifies the purchaser against the loss of its deposit (plus interest, if the purchase agreement provides that interest goes to the purchaser) which results from the developer failing to ensure that the subdivision plan or strata plan is deposited in the land title office, an occupancy approval is obtained and a transfer of the property is delivered to or registered by the purchaser, all within the time set out in the purchase agreement. A developer who enters into a deposit protection contract is responsible for payment of the premiums for the contract and may not charge the purchaser for that cost as a separate item. The contract is enforceable by the purchaser whether or not the premium is paid.
     

  • The developer must provide notice of the deposit protection contract to the purchaser.
     

  • On receiving a copy of the deposit protection contract, the lawyer, notary public or agent holding the deposit must pay the deposit to the developer.
     

  • The developer may only use the deposit funds for the "developer's own purposes". This is defined in the New Act as purposes related to the development itself, which includes the property in respect of which the deposit was paid, and the construction and marketing of that development. This prevents the developer from using the purchasersí deposits to fund another project or for its own general corporate or personal purposes.

How could the process work?

I am not aware of any deposit protection contracts which have been put into place to this date. However, based on my understanding of the practices of deposit insurance companies in Ontario, and my discussions with industry insiders, I expect that the process for implementing a deposit protection contract and accessing purchasersí deposits may be along the following lines.

Deposit protection contracts must be provided by insurance companies. Insurance companies are characteristically conservative, and I expect them to take a cautious approach to providing deposit protection contracts. The insurer will be liable to the purchaser if the developer uses the deposit and subsequently is unable to complete the development and the transfer of the property to the purchaser, and they will want some assurance that they will be able to recover whatever amount they have to pay out.

An agreement between the developer and the insurer will require the developer to repay any amounts paid out by the insurer and I expect that collateral or security from the developer will be required to be in place before any deposit protection contracts are provided to purchasers. The form of security generally required will be a second (or subsequent) mortgage on the development property, and the insurer will require that there be equity in the property to secure such mortgage. In this way, the insurer will act in essence like a bank, underwriting the project on a financial basis. The insurer may also require that regular progress, sales, and quantity surveyor reports, and similar informationrequired by the developerís construction lender, be provided to the insurer on an ongoing basis, thereby increasing the cost of reporting for the developer.

Funds from the insured deposits will be drawn down as construction costs are incurred, rather than paid out to the developer in a lump sum payment at the start of the project. I understand that the insurer may require that a portion of the construction financing be advanced to the developer prior to the first drawdown of any insured deposits, and that once draws from the insured deposits commence they will be combined with ongoing draws of construction financing.

The advantages to the developer of the ability to use the purchasersí deposits include:

  • The developer will have access to cash equity which was not previously available.

  • The developer may be able to use appraisal surplus not recognized by the construction lender as equity to secure the insurance repayment obligation.

  • The insurance premium (and costs of complying with the insurerís reporting requirements) may be less expensive than the interest and other costs and fees of second mortgage or mezzanine financing, and less than the developerís own internal rate of return requirements.

The disadvantages to the developer arising from the process outlined above include:

  • The insurer may require the developer to have equity in the project in order to secure the developerís obligations to the insurer (although it could be that insurers are more apt to recognize appraisal surpluses as equity).

  • The deposits will not be available to developers in a lump sum payment at the start of the project.

  • The process will add another level of reporting for the developer.

  • If the form of security granted to the insurer is a second (or subsequent) mortgage, the consent of the construction lender and an interlender agreement between the construction lender and the insurer may be required. As well, the existence of a second mortgage intensifies the administrative effort required when the developer is registering rights-of-way, easements and subdivision or strata plans on title and when the developer is clearing title of existing financial charges when completing sales.

British Columbia developers have been lobbying the Provincial government for several years to have the right to access the deposits paid by purchasers of real estate properties, a right which has been available to developers in Alberta, Ontario and other provinces. Clearly, the right to use the purchasersí deposits to fund project costs could be of tremendous benefit in todayís active real estate market. However, developers will have to weigh the cost of insurance premiums and the complexity of putting deposit protection contracts into place against the benefits of using purchaser deposits for development financing purposes.

We look forward to working with our developer clients in connection with deposit protection contracts and the process for obtaining access to the purchasersí deposits. We will update this report as we learn more about the actual practices of insurers and developers in British Columbia.

James Speakman
 

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